Moody’s ratifies interbank mistrust

On Tuesday I explained why it was silly to look at what markets do in the wake of ratings upgrades and downgrades; today, markets are providing a prime example. I normally hate those real-time stock tickers embedded in news stories whenever a public company is mentioned, but it’s worth checking out the WSJ article on the mass Moody’s bank downgrade today, just to see the sea of green. Every single downgraded bank is higher today, in a classic case of the market selling the rumor and buying on the news.

It’s easy — and wrong — to dismiss this move by Moody’s as a typical late-to-the-game ratings-agency move. After all, the spreads on banks’ debt have been much more consistent with these new lower ratings than they were with the old higher ratings ever since the financial crisis. Even the implicit government guarantee on TBTF banks hasn’t changed that. In general, ratings follow spreads, and so this move is in large part a capitulation to market reality.

But in fact there’s more to the downgrades than that. For one thing, they more or less kill any hope that the interbank market will ever be resuscitated. It’s been moribund since 2007, especially in Europe but also in the US, and the death of the interbank market is a very important and very worrying long-term phenomenon. It makes central banks much more important, and also much riskier. What’s more, because central banks don’t lend at different rates on the basis of perceived differences in credit risk, it hurts price discovery. And then of course there’s the trillions of dollars of loans and floating-rate bonds which are priced off Libor, which is an increasingly fictional construct.

The downgrades also institutionalize a great degree of uncertainty with regard to resolution mechanisms and what would happen if there was another banking crisis. The whole point of announcing all the downgrades at the same time is that they’re really not about idiosyncratic risk. While Citigroup is riskier than Goldman Sachs, for instance, they both got downgraded by two notches, and Goldman today has the same rating that Citigroup had yesterday. The point here is that the main credit risk facing banks’ bondholders is a broad banking crisis, rather than some localized blowup which could hurt one bank but leave everybody else unscathed. Moody’s is essentially saying that the risk of a big new banking crisis, at some point, is high. And if we have such a crisis, it’s likely that bondholders will take a hit.

That’s a good thing, from a systemic perspective: creditors, rather than taxpayers, should take the hit when banks fail. And if markets were efficient, the lower ratings and high spreads on banks’ debt would encourage them to raise more equity, carve off risky businesses, and basically become safer and more utility-like. But that is unlikely to happen, for two reasons.

Firstly there’s the collective action problem. Because a destabilizing global event would risk dinging all big banks’ bondholders, there’s no real incentive for any one big bank to become a lot safer. They need to all do it at the same time — at which point the whole system becomes safer, and there’s an incentive for any individual bank to free-ride by being the riskiest of the lot. It’s a knotty problem which regulators are doing their best to address, but it’s becoming increasingly clear that regulators’ best isn’t good enough.

Secondly, as we’ve seen, these markets are not efficient; instead, they’re increasingly reliant on central-bank liquidity and other forms of government support of the banking market. (There would be basically no mortgages at all being issued right now, for instance, if it weren’t for various government operations encouraging banks to continue making home loans.) The market has basically given up trying to make fine-grained credit distinctions between different big banks, since the banks’ disclosures are so impenetrable as to make doing so impossible. And in truth, the market never did really try to make such distinctions in the first place. We’ve just moved from a world where banks just assumed that all other banks were solid counterparties, to a world where banks just assume that they aren’t.

Which makes the banks’ protests against Moody’s actions quite ironic. Here’s the FT:

Senior staff at the banks have argued that their companies’ business models have already changed – for the better. In numerous meetings with the Moody’s analysts in charge of the downgrade, they have argued that their banks have raised billions of dollars worth of extra capital since the financial crisis.

This would be much more credible if the banks demonstrated that they believed it themselves — by starting to lend to each other again in large volume. Unless and until that happens — which means, for the foreseeable future — the global banking system is going to look sclerotic and fragile.